The opinion of some dude who hasn't done his own due diligence on the credit risk of a security is just his opinion. The opinion of a million dudes who haven't done their own due diligence on the credit risk of a security is also just their opinion. Putting their opinions together and calling it a "market" does not make it any more than the opinion of some dudes who haven't done their own due diligence.

But you can actually outsource the credit risk to someone else. Thah's just what the big Wall Street banks did when they sliced and diced all those toxic mortages, repackaged and sold them on to Düsseldorf and all the others.

But you can actually outsource the credit risk to someone else. Thah's just what the big Wall Street banks did when they sliced and diced all those toxic mortages, repackaged and sold them on to Düsseldorf and all the others.

Yes and no. You can sell it, obviously, but you can't outsource it in any meaningful sense. At most, you can buy CDS on your credit risk, but this does not hedge your credit risk - it merely substitutes one credit risk for another.

If you know that the True ProbabilityTM of non-payment is 5 %, you can discount those five per cent when making the loan.

If that renders the effective interest incompatible with the customer's business plan, then you can not make the loan. If the loan represents a large fraction of your equity, then you can not make the loan.

Non-payment will be a lot more damaging to your balance sheet than a nominal loss of 5% interest, surely? In accounting terms you have to list the bad debt in full.

But this is tangential to CDOs, where you can sell the same worthless non-coverage to multiple buyers over and over, with the certainty that if any of them try to claim on their 'coverage' you can shrug and say it's not your problem.

But as long a you have the capital to issue a lot of independent 5 % non-payment risk loans, you can get away with simply discounting it 5 %.

The salient point here is that you only get to do that with idiosyncratic risk, because systemic risk is, by its nature, not independent. This is why properly run industrial societies use government back-stops to ensure that not everyone is unemployed and broke at the same time. Because the government, as the only entity which is definitionally solvent, is the only entity which can serve as a backstop against systemic risk.

I think the key thing we should have learned from LTCM is that it's difficult to determine which risks are independent, which are not, and what sort of feedback the dependent ones will create for one another.

No, the key take-home points from the Long Term Capital Management fiasco are:

The market can remain irrational longer than you can remain solvent.

Don't bet your entire business that you're the smartest guy on the block.

Don't bet your entire business on any single transaction, particularly when that transaction does not keep the two first bullets firmly in mind.

Of course, none of this should have been in any way novel or surprising, and the fact that humanity regularly has to re-learn such simple matters of common prudence does not auger well for our collective cognitive prowess.

Non-payment will be a lot more damaging to your balance sheet than a nominal loss of 5% interest, surely? In accounting terms you have to list the bad debt in full.

Precisely! The problem with credit is that the risks are all "in the wrong direction". You get a small income stream at a rpofit in exchange for the risk of a large loss. And risk-aversion magnifies the perception of losses.

Also, diversification doesn't quite work. If you have 20 bonds with a default probability of 5% you're virtually guaranteed a loss of 5% no matter what so it's all pain, no gain. You're maybe better off gambling on just one bond where at least you have a sizeable probability of making a profit.

Naked CDS are much "better" - you pay a small fee in exchange for the chance of a big payout.

There are three stories about the euro crisis: the Republican story, the German story, and the truth. -- Paul Krugman

No, you can diversify it away as long as it is idiosyncratic risk. The fact that you are virtually guaranteed to suffer on the order of 100 defaults out of 2 thousand loans just means you have to charge 5 % extra on all the loans.

Where this breaks down is when everybody goes broke at the same time, because some right-wing idiot (but I repeat myself) was allowed to play with levers of government that he has neither the understanding nor the inclination to handle safely.

No, it means I'm virtually guaranteed a payment stream of 95 % of the nominal payment stream, assuming the defaults are uncorrelated.

You need to look at the discounted value of the expected cash flow rather than the nominal principal, for the same reason you need to look at MWh produced rather than nameplate capacity when evaluating the required price of volatile energy sources.

In a properly run economy, they are. Because the sovereign employer and investor of last resort makes sure that the macroeconomy does not go boom.

If you hand the keys to the sovereign over to right-wingers, then of course they break it. But that is not dependent on the particulars of finance theory - right-wingers break your economy because breaking countries for fun and profit is what right-wingers do.

Part of doing your due diligence is to make sure that the contract you are entering into will not cause your firm to cease to exist if shit happens. Unless said shit is so bad that your firm has a meaningful risk of ceasing to exist anyway. Part of doing your due diligence is to ask "what could possibly go wrong?" come up with a reasonably comprehensive answer, and then make contingency plans for all of those situations. Even if the contingency plan is just "in case of nuclear war, roll over and die."

project finance loans are weakly correlated to the business cycle.
This is a sector that's been studied left and right - it has lower default rates, higher recovery rates in case of default, and limited correlation to other banking assets.

Banks know that and they keep on doing it, even as it goes out of fashion.

If I pawn a clock or a house, the lender does not have a credit risk, but a risk that their evaluation of the value of the collateral will not be correct when if a time comes when the collateral needs to be sold.

But that is clearly false. Liquidity risk can be made to go away entirely (at least within the system of banks in good standing) through appropriate central bank policy. This will not, however, do anything about credit risk.

Liquidity risk is a political problem of whether you get to defer payment. Credit risk is a fundamental problem of whether you are able to make payment.

You need one to make a hotel or plane reservation, or to rent a car, even if you plan to pay cash. Many stores require a credit card to accept your check. Responsible use of a credit card builds a good credit rating, too, marking the owner as mortgage-worthy.

But people who have never had credit or need to repair a poor credit history may not qualify for a regular credit card.

In France, you get to be "interdit bancaire" (blacklisted by a government file, and denied all banking services), basically if you ever write a dud cheque. There is now (this is recent) a government-mandated minimum service that banks are obliged to provide to people who are blacklisted, which amounts to a debit card.

The advantage of this system is that you can (could, until a few years ago) write a cheque for just about anything. The banks are trying hard to stamp out the massive use of cheques (because they cost them money) and force us to use credit (or debit) cards.

Credit card balances are paid off automatically every month from your bank account, so you can't have outstanding balance on your card (what you have instead is an overdraft).

It is rightly acknowledged that people of faith have no monopoly of virtue
- Queen Elizabeth II

As do I. The bulk of debit cards here in the US can be used the same as a credit card. Secured credit cards are frankly a predatory practice no one sees fit to regulate. They prey on the patently ignorant and on those whose creditors would garnish any bank account they opened.

You have obviously not been denied a mobile phone contract because you didn't have a credit rating (good or bad: no credit rating is worse than bad credit) which you could only establish with a credit card.

There are three stories about the euro crisis: the Republican story, the German story, and the truth. -- Paul Krugman

People in that situation should be able to get pre-paid cell phones. If not, that is a real abuse, as there is no risk. As soon as you reach your pre-paid limit you can only use the phone to dial 911 or the provider's line to add more minutes. Now, if you don't have a credit card, it may be necessary to go to a retail outlet to add more minutes to your cell phone. In Arkansas there are plans specifically for low income people designed to provide them with basic communications for health and safety. Such plans provide much better phones than the cheapest available. That is probably a boondoggle for the providers.

That's just one example of what you can be denied for having no credit history. You can be denied anything that involves a credit check, which is becoming increasingly standard when dealing with corporations. You may be denied an apartment rental application, for instance. You may be denied a car rental. Your debit card may not be accepted for online payments. And so on and so forth.

There are three stories about the euro crisis: the Republican story, the German story, and the truth. -- Paul Krugman

From Wikipedia: In Hungary Sweden debit cards are far more common and popular than credit cards. Many Hungarians Swedes even refer to their debit card ("betéti kártya" "kontokort") mistakenly using the word for credit card ("hitelkártya" "kreditkort").